Investor’s worst enemy

Studies have long shown that most of us aren’t very good at investing. (See, for instance, Dalbar, Inc.’s 2007 Quantitative Analysis of Investor Behavior which analyzed the 20 year period 1987 through 2006). Driven by our emotions more than our logic, we typically buy high and sell low, which makes our ultimate returns less than they would have been if we had just steadily bought and held (then held and gradually sold) a diversified list of funds.

People in or near retirement seem to be particularly prone to such misbehavior. We’re our own worst enemy. We tend to diddle with our investments when we should be leaving well enough alone.

The usual advice for how to counter this is to practice abstinence. Establish an investment plan, then leave it alone (besides an occasional rebalancing). Don’t even look at the monthly statements; just file them away. But, since we are living, breathing organisms, we find this extremely difficult to do.

Fortunately, there is another way to shield our accumulated mutual fund wealth from our all too human urges. We can protect it with an impenetrable wall – in the form of a hired professional to manage our overall portfolio.

One very effective way to achieve this is with a separately managed, mutual fund “wrap account” from a financial advisor. But, there may be an easier way. The most recent Dalbar study found that the more widely available “allocation funds” are also providing this protection.

(For those not familiar with allocation funds: Allocation funds contain a diversified portfolio of other funds – the “underlying funds.” The types of underlying funds used differ from one allocation fund to another to reflect a range of the most important investor attributes – risk tolerance for “lifestyle” funds, or investment time horizon for “target maturity” or “lifecycle” funds. So, all the investor has to do is estimate their risk tolerance (conservative to aggressive) or time horizon (when the investment will begin being liquidated), and select a matching fund. The fund manager builds and maintains the portfolio of underlying funds over time.)

The latest Dalbar study found that investors typically hang onto allocation funds significantly longer than stock or bond funds. It also determined that stock fund investors, due to their bad habits, averaged only 4.3% annual returns, and bond fund investors 1.7%, for this very challenging 20 year period. So, if the average investor was 60% in stock funds and 40% in bond funds for this period, the overall return would have been 3.3%. Dalbar calculates the average allocation fund investors’ return for these 20 years at 3.7%, and these funds also typically have about a 60/40 stock-to-bond allocation. Disciplined buy-and-hold investors in these fund types, of course, did even better on average.

So, the best approach for most investors is to ignore their natural urges and let their well-designed portfolios of diverse mutual funds do their thing. For those of us with less confidence in our ability to control ourselves, though, it may be best to invest via an allocation fund where the structure itself protects our investments from our untoward advances, well-meaning as they may be.